Jan. 23 (Bloomberg) -- Bernard Madoff faces prison time. His investment clients will lose billions. Attorneys will grow fat and happy from the lawsuits generated by the 70-year-old’s $50 billion Ponzi scheme.

What’s in doubt is whether the regulatory structure will be redesigned and the ethical behavior of banks and hedge funds altered. That’s too bad, because the U.S. securities industry’s Madoff Moment shows how badly both need bolstering.

First, the multitude of overlapping regulators must be rationalized into a coherent few, the communication between them improved and their turf battles ended. Second, brokers, dealers, banks and fund managers must dump their “three monkeys” approach to business -- “hear no evil, see no evil, speak no evil” -- and begin blowing the whistle on competitors when they suspect wrongdoing.

They owe that to their clients, investors and the public.

In what may be a step in the right direction, Christopher Cox resigned as Securities and Exchange Commission chairman three days ago, making way for Mary Schapiro, President Barack Obama’s nominee for the job. At her confirmation hearing last week, Schapiro, head of the Financial Industry Regulatory Authority, said what the Senate Banking Committee wanted to hear.

“I will move aggressively to reinvigorate enforcement,” Schapiro told the senators. “We need an SEC that is the investor’s advocate -- that has the staff, the will and the resources necessary to move with great urgency.”

Keep Dancing

The SEC’s enforcement staff has shrunk 11 percent since 2005. The fines and other penalties it imposed dropped to about $1 billion in fiscal 2008, from $1.6 billion in 2007 and more than $3 billion in each of the preceding three years. Its biggest failure was letting Madoff keep dancing after having been alerted to his misdeeds by Harry Markopolos, a former money manager.

Contrary to popular belief, though, the problem with policing markets isn’t inadequate staffing but poor organization.

“Combine the SEC, Finra, the New York Stock Exchange regulatory group and state regulators, and you’ll have close to 10,000 employees for a little less than 5,000 registered broker- dealers,” says Peter Chepucavage, former general counsel for Nomura Securities Co. and onetime lawyer at the SEC and National Association of Securities Dealers.

One approach would be to merge them into a single regulatory agency or a federation-style structure where the states regulate the smaller firms, and the other three organizations look after the big ones. The top Wall Street firms by capital and number of employees account for as much as 95 percent of all trading volume, says Chepucavage, who is now general counsel at Washington-based Plexus Consulting Group LLC.

State Regulation

There is a precedent for such a division of labor. The states regulate all investment advisers with less than $25 million under management, and there are discussions concerning whether that should be raised to $50 million or $100 million.

The Madoff mess also illustrates the need to legally mandate that custodians -- whose job is to track trades, cash flows and the amount of money in investors’ accounts -- are independent of the money manager.

Ditto the requirement for separate administrators, whose key role is to independently value transactions. Absent an administrator, valuation is left to the person managing the money. Independent custodians and administrators are the first bulwark against fraud.

Living in Shadows

A modified regulatory structure should include hedge funds and require that they reveal how much money they have, what they are invested in and their leverage ratios. The industry is too big and its potential for igniting systemic crises too great to allow them to keep living in the shadows. Change, however, requires congressional approval.

Another loophole that Congress must close involves granting the Public Company Accounting Oversight Board, which oversees auditors of publicly traded companies, the power to inspect and take enforcement action against auditors of privately owned broker-dealers.

The good news is that Paul Kanjorski, a member of the House Financial Services Committee, last week said he is preparing the appropriate legislation. The bad news is that it will be too late to inspect the three-person firm that audited Madoff.

Then there are the dogs that didn’t bark. Several banks and hedge funds -- including Deutsche Bank AG, Credit Suisse Group AG, Goldman Sachs Group Inc., Merrill Lynch & Co., Societe Generale SA and UBS AG -- that examined Madoff, found him wanting and declined to recommend him.

Red Flags

Many were put off by Madoff’s lack of transparency, his use of a little-known auditor and especially their inability to understand how he consistently produced decent, steady returns. Although his secrecy raised red flags with some, apparently only Markopolos went to the SEC.

“Firms that said they didn’t understand Madoff’s investment strategy were in reality saying they suspected unorthodox activity,” Chepucavage says.

Banks and fund managers aren’t legally required to report suspicious behavior unless it relates to money laundering. They also resist doing so, afraid of being sued for defamation or alienating clients.

Yet they should be encouraged to report wrongdoing. They could even be rewarded if they do so.

It’s time financial institutions rose above adhering to the minimum letter of the law and acted more in the spirit of ethical behavior and with less self-interest.

You can’t run a society, or economy, solely on the basis of caveat emptor.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Michael R. Sesit in Paris at at msesit@bloomberg.net

Last Updated: January 22, 2009 19:01 EST